Corporate Governance

Question 1

Tirole’s Definition

Answer 1

“The ways in which the suppliers of finance to companies asssure themselves of getting a return on their investments” (2006)

Question 2

General

Answer 2

System of checks and balances to mitigate agency costs.

Question 3

Agency cost examples

Answer 3

1. Insufficient effort
2. Extravagent Investments
3. Entrenchment Strategies
4. Excess Risk Averseness

Question 4

Insufficient Effort

Answer 4

Allocation of work time to preferred tasks or avoiding inconvenient but valuable activities => avoiding renogotiation of supplier contracts, thorough appraisals, admin stuff, etc

Question 5

Extravegent Investments

Answer 5

Pursuit of pet projects and empire building at expense of less glamourous high NPV projects=> misaligned priorities

Question 6

Entrenchment Strategies

Answer 6

Actions that hurt shareholders to secure own position
=> investing in specific technologies/assets that align w/ their expertise
=> enganging in M&A to increase complexity of firm to increase administrative burden=> more need for managers
=> Use of earnings management to manipulate firm perfomance, e.g. aggressive revenue recognition (e.g. Groupon/Tesco)

Question 7

Self Dealing

Answer 7

Seeking personal benefit from business deals
=> Nepotism
=> making business decisions to maximise personal social capital instead of shareholder value

Question 8

Excess Risk Averseness

Answer 8

Managers cannot diversify away specific risk like shareholders can=> all of their human capital tied to one firm

=> Shareholders only care about market risk but managers care about both specific and market risk so higher required rate of return for positive NPV projects

Question 9

Enron

Answer 9

Became darling of wall street for integrating technology solutions and complex finance into the energy business

Unravelled after found using SPVs o conceal huge debts off balance sheet and understate leverage to Shareholders

Shares crashed=> shareholders paid price

Question 10

Moral Hazard in Practice

Answer 10

Effective incentives for high performance:
1. Implicit Incentives
=> passive incentives not directly tied to compensation
- risk of firing
- threat of proxy fight/takeover as result of poor performance
- threat of bankruptcy
- product market competition

2. Explicit Incentives
   - bonuses=> tie compensation to performance=> encourages myopia
   - compensation base=> provides salary insurance
   - share options=> alternative to bonuses, aligns interests

Question 11

What is Executive Compensation?

Answer 11

Describes salary packages of a companies exec managers

Question 12

Bell and van Reemem (2013)

Answer 12

Wage inequality in developed economies may be driven by executive bonuses

Question 13

Murphy (1999)

Answer 13

Cross-country, firm , industry and time heterogeneities

=> Exec compensation varies across countries/industries

Question 14

Why is CEO Pay so high?

Answer 14

1. Promotion tournaments
   => High pay for senior roles incentivise those in lower roles
   => Pyramid structures (e.g. Banks, Law firms…)
2. Signalling
   => High pay packages act as a signal of firm/employee quality
   => market assumes higher paid workforce = more productive workforce
   => also communicate healthy financial position and confidence in future cashflows, assume higher pay= higer capacity to pay
3. Not always true firms may leverage brand to pay less, lower pay may be signal of higher firm quality, wider benefits
4. CEOs are highly skilled and uniquely fitted for their position low supply/high demand
5. CEOs exposed to both market and industry risk

Question 15

Bandiera et al (2017)

Answer 15

17% of CEOs misplaced for the job

=>CEOs affect firm performance but they are not irreplaceable

Question 16

Jenter and Kanaan (2015)

Answer 16

Data from over 3000 CEO changes between 1993 and 2009=> strong evidence for high turnover
=>CEOs are punished for industry/market performance

Question 17

Hirschman (1970)

Answer 17

Exit and Voice: 2 broad approaches to corporate gov

1. Exit - Anglo American=> shareholders sell if unhappy
   - well developed stock market
   - substantial disclosure requirements, transparency requirements
   - shareholder activism
   - Proxy fights, group of shareholders consolidate votes to drive agenda
   - takeovers
2. Voice German/Japanese=> work with management
   - Trust between managament and Shareholders
   - Cross shareholding among firms/between firms and banks

Question 18

Exit - Drawbacks

Answer 18

1. encourages myopia
   => managers focus on short run profitability to avoid share sellout
   => no cohesive vision between mangement and shareholders
2. Limits amount of trust between management and shareholders

Question 19

Voice - Drawbacks

Answer 19

Limited Productivity=> reduced firing risk, less incentive for high effort (not compelling, more enlightenment and potentially more freedom to lead)

Stock market liquidity falls, investors have long time horizons

Shareholder have less leverage, may exacerbate agency issues driven by CEO hubris (Like empire building, etc)

Question 20

Does M&A add value?

Answer 20

Grossman and Hart (1980): Takeover bids only successful only if they offer at least full value for the target

=> atomistic shareholders have no impact on final bid price=> still recieve any post takeover value gain if they don’t tender offer but others do

=> no incentive for them to accept any offer below FV

Question 21

Does M&A add value? Toehold Purchases

Answer 21

Toehold purchases = purchase of small % of target company for announcement 5% in US, 3% in UK
=>allows acquirer to get a stake of firm before disclosing intent to make formal bid

=>after disclosure price rise in response so only small gain (unless firm possesses some private info)

Question 22

Synergies

Answer 22

When Value to acquirer is larger than book value of target
1. Economies of scale => why firms tend to consolidate during downturn, efficiency gains allow for cost savings

2. coplimentary assets may create value greater than sum of parts (Teece 1986)
3. More capacity to leverage tax shield=> for tax capital intensive industries (construction, energy, utilities)
4. Human Capital Benefits - access to more effective management

Question 23

Takeover Defences

Answer 23

Protection measures to prevent predation of “cheap” undervalued firms.
=> generally pushed by incumbent management and local politicians

can be viewed in 2 ways:
1. create value for existing shareholders by forcing bid price up

2. provide excess security for inefficient/incompetent managers and board members

Question 24

Takeover Defences - Poison Pill

Answer 24

Specially designed shareholder rights plan
=> Gives shareholders of target option to buy stocks of target/acquirer at a discount in case of successful takeover
=> can be set up quickly and without shareholder approval

2 types:
Flip in: Target issues new shares to shareholders at a deep discount=>instant profit for shareholder’s
=>dilutes shares held by acquiring, raises cost of TO

Flip over: Target shareholder’s have option to buy bidders stov at discount post-acquisition
=>drives down share price of bidder

Question 25

Poison Pill - Varaiya (1987)

Answer 25

Poison pills raise cost to the winning acquirer in the form of higher premia

Question 26

Poison Pill - Malarest and Walkling (1988)

Answer 26

Announcement of Poison Pills generate significant negative stock returns their abandonement leads to significant positve E[profits]

Question 27

Poison Pill - Heron and Lie (2006)

Answer 27

Poision Pills strengthens bargaining power of incumbernt shareholders, raising bids and increases.
BUT takeovers no less likely

Question 28

Takeover Defence - Golden Paraschute

Answer 28

Target management get large severence package if a bid is successful=> dont need shareholder permission in US, do in UK

Examples:
Meg Whitman, CEO HP has $91m severence package
Staples and Office Depot proposed merger => Office Depot CEO entitled to $39m in accelerated vesting of stock options

Question 29

Takeover Defences - White Knights

Answer 29

Management lines up friendly bidder to tend of hostile approaches
=> P. Soo-Shiong’s $70m investment in Tribune Publishing as they fend off takeover from Gannett Co.

Question 30

Takeover Defences - Staggered Board

Answer 30

Only allows a proportion (usually 1/3) of board to reappointed each year.

Data suggests negative correlation between staggered boards and firm value (Gomper et al, 2003)
=> may discourage acquisitions that would increase shareholder value (Grossman and Hart, 1980)

Job security for Managers/Directors encourages LR decision making (Stein, 1988)

Question 31

Takeover Defences - Supermajority

Answer 31

Requiring more than 50% of shareholders to approve a merger

=> depends on company charter but usually 67-90%

Question 32

Takeover Defences - Leveraged Recapitalisation

Answer 32

Target takes on additional devt w/ intention of paying a cash dividend or repurchasing stocks to increase D/E
=>increase leverage ration makes target less attractive

Question 33

M&A The Bidder - Rational

Answer 33

Rationale:

1. Synergies
2. Undervalued Target
3. Poor Management
4. Tax Benefits - D/E increase buids up tax shield

C

Question 34

M&A The Bidder - Concerns

Answer 34

Moral Hazard

• FCF agency cost (Jensen, 1984)
• Empire building: vanity project, signalling, salary leverage

Overpayment
=> CEO Hubris (Hayward & Hambrick)
=> Bidding wars “winner’s curse” (Varaiya, 1988)

Diversification
=>Shareholders can diversify away specific risk themselves so do not value firm diversification (Porter 1987)
=> Shareholders may face borrowing constraints
=> Also high growth, larger firms may have access to better growth opportunities than individual shareholders

Question 35

Voice: Blockholders

Answer 35

Shareholders with large % of shares
Vote to improve management instead of just selling shares
=> indirect, influence management through board
- less disruptive
- no loss in share value do to market inefficiency
=> unlikely to be pursued by atomisitic investors, not worth the cost

Question 36

Anglo/American Voice

Answer 36

Blocks tend to hold shares for less than 12 months
=essentially exit investors

US Banks prohibited from active investment in non-financial firms, and cannot influence management
=>risk equitable subordination

Increased appointment of independent directors
=>Potential reverse causality, can’t observe counter factual

Question 37

Voice downsides

Answer 37

Active investors act in self interest=> expropriate other shareholders in pursuit of private agenda

Insider Blockholders (management) have interest in seeing stocks rise
=>BUT may opt to max private benefits instead
=> only bear a proportion of costs associated with managerial decisions but gain all benefits

Bank Blockholders unlikely to interfere unless risk of financial distress

Question 38

Bertrand and Mullainathan (2000)

Answer 38

Skimming Theory
CEO set own pay => leverage postion to manipulate compensation committee

Correlation between size of Shareholders and average CEO pay. 7.5% w/o large shareholders, 2.5 w/ large shareholders

Firms w/ blockholders had salaries more sensitive accounting performance=> less sensitive to “luck dollar”

Skimming more likely to occur when there is less scrutiny
=> stock options not realised on FS till exercised=> can go unnoticed
=> more scrutiny during periods of high exogenous performance